Sunday, March 30, 2014

Deposits create loans or the other way round?

The “loans create money” brigade have got all excited over the last two weeks or so as a result of thisBank of England publication which says that loans create deposits / money.

Actually the cause effect relationship runs both ways. That is, the commercial bank system cannot lend an extra £X unless someone or a collection of people are prepared to deposit approximately £X in the commercial bank system. That is, the relationship between depositors and borrowers is a bit like the relationship between apple growers and apple consumers: the market price for apples is not determined exclusively by buyers or sellers.

Or as Nick Rowe put it, “And commercial banks, neither individually nor collectively, can create loans, unless they can persuade people to hold their deposits and not hold central bank money instead.”

At least the latter point by Nick is right if the economy is at capacity. That is, in the latter scenario, if commercial banks did simply credit the accounts of borrowers without bothering to see if they had enough depositor money, the result would be increased aggregate demand. That is, the fact of failing to “persuade people to hold their deposits” would mean that those depositors would try to spend away their increased stock of money, thus demand would rise, which would be inflationary, which the central bank / government would counter, e.g. by raising interest rates or increased taxes. Result: no extra borrowing.

In contrast, if the economy is BELOW capacity, lending money into existence with the resulting depositors trying to spend away their new stock of money would increase demand. But that wouldn’t matter to the extent that extra demand was called for.